You should read the following discussion in conjunction with our Consolidated Financial Statements and related Notes included elsewhere in this annual report. Historical results are not necessarily indicative of trends in operating results for any future period.

The statements contained in this annual report that are not historical facts are forward-looking statements that involve a number of risks and uncertainties. The actual results of the future events described in such forward-looking statements in this annual report could differ materially from those stated in such forward-looking statements. Among the factors that could cause actual results to differ materially are the risks and uncertainties discussed in Item 1A. Risk Factors and the uncertainties set forth from time to time in our other public reports and filings and public statements.

Overview

Our long-term strategy continues to be providing the best small and medium-sized businesses in the United States with the opportunity to participate in our unique human resources service offering, thereby leveraging our buying power and expertise to provide additional valuable services to clients. Our most comprehensive HR business offering is provided through our PEO services, now known as our Workforce OptimizationTM solution, which encompasses a broad range of human resources functions, including payroll and employment administration, employee benefits, workers' compensation, government compliance, performance management and training and development services. Our overall operating results can be measured in terms of revenues, payroll costs, gross profit or operating income per worksite employee per month. We often use the average number of worksite employees paid during a period as our unit of measurement in analyzing and discussing our results of operations.

In addition to Workforce Optimization, we offer Human Capital Management, Payroll Services, Time and Attendance, Performance Management, Organizational Planning, Recruiting Services, Employment Screening, Financial Services, Expense Management, Retirement Services and Insurance Services, (collectively "Adjacent Businesses"), many of which are offered via desktop applications and SaaS delivery models. These other products or services are offered separately, as a bundle, or along with Workforce Optimization.

We ended 2012 averaging 129,345 paid worksite employees in the fourth quarter, which represents a 6.0% increase over the fourth quarter of 2011. Approximately 17% of our paid worksite employees were in our mid-market sector for the year ended December 31, 2012, which is defined as companies with 150 to 2,000 worksite employees. We expect the average number of paid worksite employees per month to be in the range of 123,250 to 123,750 in the first quarter of 2013.

Our 2012 average gross profit per worksite employee per month was $253, a $2 increase over 2011. Higher gross profit per worksite employee per month in 2012 compared to 2011 was primarily the result of a higher contribution from our direct cost programs.

Operating expenses increased 6.9% in 2012 to $314.7 million. On a per worksite employee per month basis, operating expenses decreased from $210 in 2011 to $208 in 2012. The 2012 operating expenses included a $4.2 million impairment charge related to our Performance Management reporting unit. Please read Note 5 to the Consolidated Financial Statements, "Goodwill and Other Intangible Assets," for additional information.

Our net income in 2012 was $40.4 million, a $9.9 million increase compared to 2011. We ended 2012 with working capital of $115.7 million. During 2012, we paid $42.7 million in dividends and repurchased shares at a cost of $16.9 million.

Revenues

We account for our revenues in accordance with Accounting Standards Codification ("ASC") 605-45, Revenue Recognition. Our Workforce Optimization gross billings to clients include the payroll cost of each worksite employee at the client location and a markup computed as a percentage of each worksite employee's payroll cost. We invoice the gross billings concurrently with each periodic payroll of our worksite employees. Revenues, which exclude the payroll cost component of gross billings, and therefore, consist solely of the markup, are recognized ratably over the payroll period as worksite employees perform their service at the client worksite. This markup includes pricing components associated with our estimates of payroll taxes, benefits and workers' compensation costs, plus a separate component related to our HR services. We include revenues that have been recognized but not invoiced in unbilled accounts receivable on our Consolidated Balance Sheets.

Our revenues are primarily dependent on the number of clients enrolled, the resulting number of worksite employees paid each period and the number of worksite employees enrolled in our benefit plans. Because our total markup is computed as a percentage of payroll cost, certain revenues are also affected by the payroll cost of worksite employees, which may fluctuate based on the composition of the worksite employee base, inflationary effects on wage levels and differences in the local economies of our markets.

Direct Costs

The primary direct costs associated with our Workforce Optimization revenue-generating activities are:

· employment-related taxes ("payroll taxes")

· costs of employee benefit plans

· workers' compensation costs

Payroll taxes consist of the employer's portion of Social Security and Medicare taxes under FICA, federal unemployment taxes and state unemployment taxes. Payroll taxes are generally paid as a percentage of payroll cost. The federal tax rates are defined by federal regulations. State unemployment tax rates are subject to claim histories and vary from state to state.

Employee benefits costs are comprised primarily of health insurance premiums and claims costs (including dental and pharmacy costs), but also include costs of other employee benefits such as life insurance, vision care, disability insurance, education assistance, adoption assistance, a flexible spending account and a worklife program.

Workers' compensation costs include administrative and risk charges paid to the insurance carrier, and claims costs, which are driven primarily by the frequency and severity of claims.

Gross Profit

Our gross profit per worksite employee is primarily determined by our ability to accurately estimate and control direct costs and our ability to incorporate changes in these costs into the gross billings charged to Workforce Optimization clients, which are subject to contractual arrangements that are typically renewed annually. We use gross profit per worksite employee per month as our principal measurement of relative performance at the gross profit level.

Operating Expenses

· Salaries, wages and payroll taxes - Salaries, wages and payroll taxes are primarily a function of the number of corporate employees and their associated average pay and any additional incentive compensation. Our corporate employees include client services, sales and marketing, benefits, legal, finance, information technology, administrative support personnel and those associated with our ABUs.

· Stock-based compensation - Our stock-based compensation relates to the recognition of non-cash compensation expense over the vesting period of restricted stock awards.

· Commissions - Commission expense consists primarily of amounts paid to sales managers and BPAs. Commissions are based on the number of new accounts sold and a percentage of revenue generated by such personnel.

· Advertising - Advertising expense primarily consists of media advertising and other business promotions in our current and anticipated sales markets, including the Insperity ChampionshipTM presented by UnitedHealthcare® sponsorship. In 2011, certain costs incurred as a result of our rebranding initiative are also included in advertising.

· General and administrative expenses - Our general and administrative expenses primarily include:

· rent expenses related to our service centers and sales offices

· outside professional service fees related to legal, consulting and accounting services, and acquisition transaction expenses

· administrative costs, such as postage, printing and supplies

· employee travel expenses

· technology and facility repairs and maintenance costs

· rebranding initiative costs in 2011

· Depreciation and amortization - Depreciation and amortization expense is primarily a function of our capital investments in corporate facilities, service centers, sales offices, technology infrastructure and that associated with our acquisitions.

· Impairment charge - Non-cash expense associated with the decline in fair value of intangible assets, including goodwill. Please read Note 5 to the Consolidated Financial Statements, "Goodwill and Other Intangible Assets," for additional information.

Income Taxes

Our provision for income taxes typically differs from the U.S. statutory rate of 35%, due primarily to state income taxes and non-deductible expenses. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities used for financial reporting purposes and the amounts used for income tax purposes. Significant items resulting in deferred income taxes include prepaid assets, accruals for workers' compensation expenses, stock-based compensation and depreciation. Changes in these items are reflected in our financial statements through a deferred income tax provision.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The preparation of these financial statements requires our management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate these estimates, including those related to health and workers' compensation insurance claims experience, client bad debts, income taxes, property and equipment, goodwill and other intangibles, and contingent liabilities. We base these estimates on historical experience and on various other assumptions that management believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

We believe the following accounting policies are critical and/or require significant judgments and estimates used in the preparation of our Consolidated Financial Statements:

· Benefits costs - We provide group health insurance coverage to our worksite employees through a national network of carriers including UnitedHealthcare ("United"), UnitedHealthcare of California, Kaiser Permanente, Blue Shield of California, HMSA BlueCross BlueShield of Hawaii, Unity Health Plan and Tufts, all of which provide fully insured policies or service contracts.

The health insurance contract with United provides the majority of our health insurance coverage. As a result of certain contractual terms, we have accounted for this plan since its inception using a partially self-funded insurance accounting model. Accordingly, we record the costs of the United plan, including an estimate of the incurred claims, taxes and administrative fees (collectively the "Plan Costs"), as benefits expense in the Consolidated Statements of Operations. The estimated incurred claims are based upon: (i) the level of claims processed during the quarter; (ii) estimated completion rates based upon recent claim development patterns under the plan; and (iii) the number of participants in the plan, including both active and COBRA enrollees. Each reporting period, changes in the estimated ultimate costs resulting from claim trends, plan design and migration, participant demographics and other factors are incorporated into the benefits costs.

Additionally, since the plan's inception, under the terms of the contract, United establishes cash funding rates 90 days in advance of the beginning of a reporting quarter. If the Plan Costs for a reporting quarter are greater than the premiums paid and owed to United, a deficit in the plan would be incurred and we would accrue a liability for the excess costs on our Consolidated Balance Sheets. On the other hand, if the Plan Costs for the reporting quarter are less than the premiums paid and owed to United, a surplus in the plan would be incurred and we would record an asset for the excess premiums on our Consolidated Balance Sheets. The terms of the arrangement with United require us to maintain an accumulated cash surplus in the plan of $9.0 million, which is reported as long-term prepaid insurance. As of December 31, 2012, Plan Costs were less than the premiums paid and owed to United by $18.5 million. As this amount is in excess of the agreed-upon $9.0 million surplus maintenance level, the $9.5 million balance is included in prepaid insurance, a current asset, on our Consolidated Balance Sheets. The premiums owed to United at December 31, 2012, were $10.5 million, which is included in accrued health insurance costs, a current liability, on our Consolidated Balance Sheets.

We believe the use of recent claims activity is representative of incurred and paid trends during the reporting period. The estimated completion rate used to compute incurred but not reported claims involves a significant level of judgment. Accordingly, an increase (or decrease) in the completion rates used to estimate the incurred claims would result in an increase (or decrease) in benefits costs and net income would decrease (or increase) accordingly.

The following table illustrates the sensitivity of changes in the completion rates on our estimate of total benefit costs of $939.5 million in 2012:

                                      Change in            Change in
                  Change in         Benefits Costs        Net Income
               Completion Rate      (in thousands)      (in thousands)

                   (2.5)%          $        (18,064 )   $         7,370
                   (1.0)%                    (7,226 )             2,948
                    1.0%                      7,226              (2,948 )
                    2.5%                     18,064              (7,370 )

· Workers' compensation costs - Since October 1, 2007, our workers' compensation coverage has been provided through our arrangement with the ACE Group of Companies ("ACE"). Under our arrangement with ACE (the "ACE Program"), we bear the economic burden for the first $1 million layer of claims per occurrence, and effective October 1, 2010, we also bear the economic burden for a maximum aggregate amount of $5 million per policy year for claim amounts that exceed the first $1 million. ACE bears the economic burden for all claims in excess of these levels. The ACE Program is a fully insured policy whereby ACE has the responsibility to pay all claims incurred under the policy regardless of whether we satisfy our responsibilities. Our coverage from September 1, 2003 through September 30, 2007 was provided through selected member insurance companies of American International Group, Inc.

Because we bear the economic burden for claims up to the levels noted above, such claims, which are the primary component of our workers' compensation costs, are recorded in the period incurred. Workers' compensation insurance includes ongoing health care and indemnity coverage whereby claims are paid over numerous years following the date of injury. Accordingly, the accrual of related incurred costs in each reporting period includes estimates, which take into account the ongoing development of claims and therefore requires a significant level of judgment.

We employ a third party actuary to estimate our loss development rate, which is primarily based upon the nature of worksite employees' job responsibilities, the location of worksite employees, the historical frequency and severity of workers' compensation claims, and an estimate of future cost trends. Each reporting period, changes in the actuarial assumptions resulting from changes in actual claims experience and other trends are incorporated into our workers' compensation claims cost estimates. During the years ended December 31, 2012 and 2011, Insperity reduced accrued workers' compensation costs by $13.1 million and $11.4 million, respectively, for changes in estimated losses related to prior reporting periods. Workers' compensation cost estimates are discounted to present value at a rate based upon the U.S. Treasury rates that correspond with the weighted average estimated claim payout period (the average discount rate utilized in 2012 and 2011 was 0.6% and 1.1%, respectively) and are accreted over the estimated claim payment period and included as a component of direct costs in our Consolidated Statements of Operations.

Our claim trends could be greater than or less than our prior estimates, in which case we would revise our claims estimates and record an adjustment to workers' compensation costs in the period such determination is made. If we were to experience any significant changes in actuarial assumptions, our loss development rates could increase (or decrease), which would result in an increase (or decrease) in workers' compensation costs and a resulting decrease (or increase) in net income reported in our Consolidated Statements of Operations.

The following table illustrates the sensitivity of changes in the loss development rate on our estimate of workers' compensation costs totaling $51.6 million in 2012:

                                   Change in Workers'         Change in
              Change in Loss       Compensation Costs        Net Income
             Development Rate        (in thousands)        (in thousands)

                  (5.0)%          $             (2,491 )   $         1,470
                  (2.5)%                        (1,246 )               735
                   2.5%                          1,246                (735 )
                   5.0%                          2,491              (1,470 )

At the beginning of each policy period, the insurance carrier establishes monthly funding requirements comprised of premium costs and funds to be set aside for payment of future claims ("claim funds"). The level of claim funds is primarily based upon anticipated worksite employee payroll levels and expected workers' compensation loss rates, as determined by the carrier. Monies funded into the program for incurred claims expected to be paid within one year are recorded as restricted cash, a short-term asset, while the remainder of claim funds are included in deposits, a long-term asset in our Consolidated Balance Sheets. In 2012, we received $2.5 million for the return of excess claim funds related to the ACE program, which reduced deposits. As of December 31, 2012, we had restricted cash of $47.1 million and deposits of $64.2 million. We have estimated and accrued $111.7 million in incurred workers' compensation claim costs as of December 31, 2012. Our estimate of incurred claim costs expected to be paid within one year are recorded as accrued workers' compensation costs and included in short-term liabilities, while our estimate of incurred claim costs expected to be paid beyond one year are included in long-term liabilities on our Consolidated Balance Sheets.

· Contingent liabilities - We accrue and disclose contingent liabilities in our Consolidated Financial Statements in accordance with ASC 450-10, Contingencies. GAAP requires accrual of contingent liabilities that are considered probable to occur and that can be reasonably estimated. For contingent liabilities that are considered reasonably possible to occur, financial statement disclosure is required, including the range of possible loss if it can be reasonably determined. From time to time we disclose in our financial statements issues that we believe are reasonably possible to occur, although we cannot determine the range of possible loss in all cases. As issues develop, we evaluate the probability of future loss and the potential range of such losses. If such evaluation were to determine that a loss was probable and the loss could be reasonably estimated, we would be required to accrue our estimated loss, which would reduce net income in the period that such determination was made.

· Deferred taxes - We have recorded a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, our ability to realize our deferred tax assets could change from our current estimates. If we determine that we would be able to realize our deferred tax assets in the future in excess of the net recorded amount, an adjustment to reduce the valuation allowance would increase net income in the period that such determination is made. Likewise, should we determine that we will not be able to realize all or part of our net deferred tax assets in the future, an adjustment to increase the valuation allowance would reduce net income in the period such determination is made.

· Allowance for doubtful accounts - We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to pay their comprehensive service fees. We believe that the success of our business is heavily dependent on our ability to collect these comprehensive service fees for several reasons, including:

· the fact that we are at risk for the payment of our direct costs and worksite employee payroll costs regardless of whether our clients pay their comprehensive service fees

· the large volume and dollar amount of transactions we process

· the periodic and recurring nature of payroll, upon which the comprehensive service fees are based

To mitigate this risk, we have established very tight credit policies. We generally require our Workforce Optimization clients to pay their comprehensive service fees no later than one day prior to the applicable payroll date. In addition, we maintain the right to terminate the CSA and associated worksite employees or to require prepayment, letters of credit or other collateral if a client's financial position deteriorates or if the client does not pay the comprehensive service fee. As a result of these efforts, losses related to customer nonpayment have historically been low as a percentage of revenues. However, if our clients' financial conditions were to deteriorate rapidly, resulting in nonpayment, our accounts receivable balances could grow and we could be required to provide for additional allowances, which would decrease net income in the period that such determination was made.

· Property and equipment - Our property and equipment relate primarily to our facilities and related improvements, furniture and fixtures, computer hardware and software and capitalized software development costs. These costs are depreciated or amortized over the estimated useful lives of the assets. If we determine that the useful lives of these assets will be shorter than we currently estimate, our depreciation and amortization expense could be accelerated, which would decrease net income in the periods of such a determination. In addition, we periodically evaluate these costs for impairment. If events or circumstances were to indicate that any of our long-lived assets might be impaired, we would assess recoverability based on the estimated undiscounted future cash flows to be generated from the applicable asset. In addition, we may record an impairment loss, which would reduce net income, to the extent that the carrying value of the asset exceeded the fair value of the asset. Fair value is generally determined using an estimate of discounted future net cash flows from operating activities or upon disposal of the asset.

· Goodwill and other intangibles - Goodwill is tested for impairment on an annual basis and between annual tests in certain circumstances, and is written down when impaired. Purchased intangible assets other than goodwill are amortized over their useful lives unless these lives are determined to be indefinite. Our purchased intangible assets are carried at cost less accumulated amortization. Amortization is computed over the estimated useful lives of the respective assets, which ranges from three to 10 years. Please read Note 5 to the Consolidated Financial Statements, "Goodwill and Other Intangible Assets," for additional information.

New Accounting Pronouncements

We believe that we have implemented the accounting pronouncements with a material impact on our financial statements and do not believe there are any new or pending pronouncements that will materially impact our financial position or results of operations.

Results of Operations

Year Ended December 31, 2012 Compared to Year Ended December 31, 2011.

The following table presents certain information related to our results of
operations:

                                                                        Year ended December 31,
                                                           2012                      2011                 % Change
                                                         (in thousands, except per share and statistical data)
Revenues (gross billings of $12.992 billion and
$11.700 billion, less worksite employee payroll
cost of $10.833 billion and $9.724 billion,
respectively)                                        $      2,158,824          $      1,976,219                 9.2 %
Gross profit                                                  382,221                   351,775                 8.7 %
Operating expenses                                            314,727 (1)               294,461                 6.9 %
Operating income                                               67,494                    57,314                17.8 %
Other income (expense)                                            796                    (6,539 )(2)          112.2 %
Net income                                                     40,402                    30,470                32.6 %
Diluted net income per share of common stock                     1.56                      1.16                34.5 %

Statistical Data:
Average number of worksite employees paid per
month                                                         125,650                   116,839                 7.5 %
Revenues per worksite employee per month(3)          $          1,432          $          1,410                 1.6 %
. . .